A New Test for Private Credit

Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief U.S.  Equity Strategist. 

Today on the podcast I’ll be discussing  why the balance between the upside and the downside is actually better than at the start of the year.

It's Monday, March 30th at 11:30 am in New York.  

So, let’s get after it.

Everyone I’ve been speaking with lately is focused on the same things: the conflict in Iran, oil prices, and of course, AI—whether it’s CapEx, disruption of labor markets, and efficiency. When I look at how markets are trading, I come away with a different conclusion than the consensus.

First, the U.S. equity market is far less complacent about growth risks than people think.

Consider this: more than half of the Russell 3000 stocks are down at least 20 percent from their highs, while the S&P 500’s Price/Earnings multiple is down 17 percent. That’s not complacency. That’s a well advanced correction consistent with prior growth scares, if not an outright recession.

Second, let’s talk about oil, everyone’s top concern.

Historically, oil spikes have often ended business cycles. However, recessions only occurred when earnings growth was decelerating or outright negative. Today, it’s accelerating and running close to 14 percent while forward earnings growth is north of 20 percent. Meanwhile, the magnitude of the oil move, on a year-over-year basis, is only about half of what we saw in the recession outcomes.

In other words, the market isn’t pricing in a recession because the odds of that happening appear low. Instead, we believe it’s pricing in continued uncertainty about oil and other key resources until there is ultimately a resolution where tanker flows resume and prices stabilize or come back down.

From my observations, I think interest rates are weighing more heavily on U.S. stocks rather than oil. Specifically, the correlation between equities and yields has flipped deeply negative. Stocks are extremely sensitive to moves in higher yields—more so than they’ve been in years. This is mainly due to the recent hawkish pivot by the Fed and other central banks.

As a result, we’re also approaching the 4.5 percent level on 10-year Treasury yields, a point where we typically observe further equity valuation compression.

Finally, bond volatility is also rising, and equity valuations are always sensitive to that. The good news is that the Fed is more sensitive to bond than stock volatility and any further rise could likely lead to a Fed pivot back to a more dovish stance. 

In short, the tightening in financial conditions driven by rates and bond volatility is the bigger near-term risk, not the geopolitical backdrop. Ironically, it’s also what could provide relief. At the end of the day, I still think we’re getting closer to the end of this correction; and when I look at the next 6 to 12 months, the risk-reward looks better today than it did at the start of the year.

On the positioning side, I’m also seeing some interesting shifts.

Defensive stocks and Gold had a strong run from early January right up until tensions in the Middle East began at the end of February. But they have underperformed significantly since. Meanwhile, some of the better-performing sectors recently have been the more cyclical ones. That tells me the market got ahead of these concerns and may be ready to look past it, sooner than most investors.

As for AI, there’s still a lot of focus on disruption, but I think the near-term story is more about efficiency and margin expansion. We’re not seeing a demand shock that would trigger a traditional labor cycle. Instead, we’re seeing companies use AI to right-size costs and improve productivity.

Bottom line, the market has already done a lot of the heavy lifting of this correction by discounting the war, higher oil prices, AI, and credit risks. What it’s wrestling with now is the risk of a monetary policy mistake with central banks staying too tight for too long.

If that hawkish bent starts to ease, which it probably will if bond volatility rises much further, the resumption of the bull market is likely to arrive faster than most expect.

Thanks for tuning in; I hope you found it informative and useful. Let us know what you think by leaving us a review. And if you find Thoughts on the Market worthwhile, tell a friend or colleague to try it out!

Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley.

Vishwas Patkar: And I'm Vishwas Patkar, Head of U.S. Credit Strategy at Morgan Stanley.

Andrew Sheets: And today on the program, we're going to talk about two of the biggest questions facing global credit markets. A rush of issuance, and questions around private credit.

It's Friday, March 27th at 2pm in London.

Vishwas, it's great to have you in town, talking over what I think are two of the biggest questions that are hanging over the global credit market. A large wave of issuance and a lot of questions around a segment of that market, often known as private credit.

So, let's dig into those in turn. I want to start with issuance. You know, you and your team had a pretty aggressive forecast at the start of the year, for a significant level of supply. How's that going? How is it shaping out? We're now almost through the first quarter…

Vishwas Patkar: Yeah. So, we came into the year expecting a record, [$]2.25 trillion of gross issuance in investment grade. That's 25 percent higher than last year. That would mark a record one year number for investment grade and for the high yield market. We expected about [$]400 billion of issuance; up roughly 30 percent.

If I were to mark those, the forecast is roughly playing out as expected through mid-March. IG issuance is up about 21 percent. High yield issuance is up about 25 percent. So far at least it's along the lines of what we'd call for. More importantly though, when I think about the drivers of the issuance, that I think in some ways is a little more validating.

Because there were two big components of what was going to drive the issuance.

One was AI related issuance from the large hyperscalers, and the second was a decent uptick in M&A. And we've seen both of those. So, year-to-date, we've had north of [$]80 billion of issuance from hyperscalers alone in the dollar market. That's on top of significant non-USD issuance that we've had this year.

So, I think this idea of AI CapEx investments and by extension issuance being somewhat agnostic to macro, that seems to be playing out so far.

Andrew Sheets: So, let's talk a little bit more about that – because, you know, this is a new development. This kind of is a new regime to have this much supply, sort of, somewhat independent of a very volatile macro backdrop.

And you know, maybe if you could talk just a little bit more about what we're learning about the issuers. What do they care about, what is bringing them to market, and then maybe what would cause them to slow down or speed up?

Vishwas Patkar: Yeah, I think we've learned a couple of things, right? First is – this issuance is being driven by investments that are not opportunistic, right? They are competitive in nature. Clearly there is an arms race to figure out who will win the AI race.  I think a second leg of it is the issuance is somewhat spread agnostic. So, you know, in credit we look at this metric called new issue concessions, which is effectively how much is a company paying in terms of excess funding costs relative to their bonds outstanding. And what we've seen with some of the larger deals is that new issue concessions are well above average.

And that's pretty important in the grand scheme of things because, you know, we're talking about one sector that is driving AI infrastructure. But when you have issuance that comes in size, and it comes wide to where existing bonds are, we think that has knock-on effects repricing other companies that are downstream of those names.

Andrew Sheets: So, we have a market for issuing corporate debt that's pretty wide open. You know, as you mentioned, very high levels of issuance and supply going through, despite [what] would've been a lot of concerns. And one of those concerns is the conflict in Iran.

But another concern that's been cropping up is a concern around this market often known as private credit where you've seen a lot of focus, a lot of headlines, volatility in some of the managers of private credit. But also, I think this is an area where less is known. And where there's still a lot of confusion about what it is and how it's performing.

So, for the second set of questions, Vishwas, maybe we could just start with, you know, when you think about private credit, what is it to you? And how do you break up the market?

Vishwas Patkar: Yeah, so I think at a very high level, you can think about private credit as you know, capital that is provided by non-bank lenders. And in some ways – that is not broadly syndicated. So it's different from investment grade bonds or high yield bonds or leverage loans in that respect. You know, the second factor I laid out.

You know, private credit overarchingly is a big umbrella term. It includes direct lending to businesses. It includes infrastructure finance, project finance, the private placement market, asset-based finance. So, there are a lot of subcomponents.

Now, you know, to your point where the market's a little worried and there is growing anxiety is around the direct lending portion of private credit. That segment of the market has grown substantially over the last decade. It was about [$]500 billion or so 10 years ago. It's about [$]1.3 trillion right now.

Andrew Sheets: And this is lending directly to companies?

Vishwas Patkar: Yeah. This is lending directly to companies. Leverage typically tends to be higher than what you see in the public market. So, one of the challenges around navigating the risks are, you know, when you get a bunch of negative headlines that isn't necessarily the readily available information to either disprove or validate it.

So, I think that's some of the anxiety, which is building among the investor base. Our view is, you know, these risks are significant and investors should be cognizant of what's happening. 

Andrew Sheets: So maybe just to take a step back a little bit there. Why have investors been more worried about the private credit space?

Have we seen particular events? Or is it more, kind of, other factors that you think have driven this increased focus?

Vishwas Patkar: Yeah, I think it's been a rolling set of factors. This year the whole story has really been about software and concerns about AI disruption. But before I get into that, I think it was a process that really began, I would say, second half of last year.

So, private credit really had its moment in the sun a few years ago where inflows were massive. The public market was choppy while the Fed was hiking rates, and a lot of stress issuers were choosing to raise capital via direct lenders. And at that time, spreads in the private credit market were also very attractive.

What you've seen last year is private credit AUM was effectively flat. The fee income being generated on the loans has come down as the Fed has eased policy and the spread on private credit versus the public market has also narrowed. So, what started off, I think, was more macro. It was driven more by what was happening on the policy front…

Andrew Sheets: More yield compression. Less yield for investors, which caused them to be just a little bit less attracted to the space…

Vishwas Patkar: Absolutely, yeah. And I think that was largely the driver of, you know, the correction in some of these asset manager stocks to begin with. Then you had some of the headlines around specific single name headlines. Double pledging of collateral, some accounting malpractices, which, you know, I think we can say with the benefit of hindsight, those were idiosyncratic. Those were one offs. But again, you know, doesn't make for a positive headline when you get news flow to that effect.

And then this year, as I said, it's really been about concerns around the software…

Andrew Sheets: Which is a very big part of the private credit market.

Vishwas Patkar: It is a very big part of the private credit market. it made up for almost a third of all LBOs that were originated between 2018 through 2022. And in fact, really if you look at 2021 when interest rates were very low, a lot of the outstanding software loans were originated in those really weak vintages.

And so, you know, I think AI disruption has maybe been the catalyst to drive some of this price action. But that's on top of software, where a lot of loans were originated with high leverage.   But now that, you know, you have a very disruptive force around margins, potentially looming, the concern has now shifted towards what do balance sheets look like. And the software sector is very levered. In the bank loan market, for example, more than 50 percent of software loans outstanding are rated B- or lower.

And one extension of that is that, you know, you have a non-trivial amount of debt that is maturing in the next few years. So, through 2028, we see about [$]65 billion of software loans maturing largely in lower quality cohort.

So, you know, even before we get clarity around how AI will diffuse and disrupt or will not disrupt these names, the issue is really refinancing. In this period of uncertainty, will all these software loans over the next 12 to 18 months, will they have the capital to determine out their maturities?

Andrew Sheets: So, Vishwas, maybe just in closing, as you're going around and talking to credit investors at the moment, what do you think are the two or three biggest, kind of, high level takeaways and views that you're trying to get across?

Vishwas Patkar: A few things I would say. So, specifically on private credit, we are saying that, you know, I think we are in for a period where returns might be subpar. It is possible that private credit sees AUM growth that is sluggish, maybe even down year-over-year this year. But we would not conflate that with something that's systemic. And I think it's very important to lay that out. But importantly, some of the linkages to the banking system are through, you know, leverage that is significantly lower in this cycle than what we've seen in the past, say prior to the GFC. So that's one.

Second, I continue to think that the aspect of issuance being very high and somewhat agnostic to macro conditions, that's been validated so far. And when I look at what credit markets are priced for, in aggregate, we think valuations are still too tight. And that's not withstanding everything that's going on in the Middle East.

You know, we clearly have a commodity price shock to navigate. And that can have a feedback loop via what central banks will do. And the U.S. consumer. But I would say just the convexity of credit is very weak. If, let's say, we get a…

Andrew Sheets: Limited upside versus relative to more downside…

Vishwas Patkar: Very limited upside. And downside, if we get both a technical and a fundamental –   and why it is significant.

And the third thing I would say is it makes sense to own hedges here. You know, again, hedges can be expensive, can lead to loss of carry. But they can also be a very efficient way to protect yourself. And if you look at this time last year in the lead up to Liberation Day, credit had held up really well for the first, say, five or six weeks of that sell off.

But then when it moved, it moved very quickly. And in some ways, you know, if you; if investors were able to protect themselves through that last leg of volatility, that effectively provided a very good entry point to capture the rally that played out thereafter.

Andrew Sheets: Vishwas. I think that's a great thing to keep in mind. Thanks for taking the time to talk.

Vishwas Patkar: Alright. Thank you for having me here, Andrew.

Andrew Sheets: And thank you as always for your time. If you find Thoughts on the Market useful, let us know by leaving review wherever you listen. And also tell a friend or colleague about us today.